**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-QSB**

 

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| **ý**                                                                                                                                                                                                                                                                              | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                    |
| **For the quarterly period ended March 31, 2005**                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                                                                                                                                                                                                                                                    |
| **For  the transition period from                   to                       ** |
|                                                                                                                                                                                                                                                                                    |
| **Commission File Number   0-20191**                                                                                                                                                                                                                                               |

 

**INTRUSION INC.**

(Exactname of small business issuer as specified in its charter)

 
| **Delaware**                                                     | ** ** | **75-1911917**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**1101 East Arapaho Road, Richardson, Texas 75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days:

Yes ý No o

 

The number of shares outstandingof the Registrant’s Common Stock, $0.01 par value, on May 5, 2005 was6,138,030.

 

Transitional Small BusinessDisclosure Forman (check one):  Yes o No ý

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL  INFORMATION**                                                              |   |
|------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                       |   |
| Item 1.  Financial Statements                                                                         |   |
|                                                                                                       |   |
| Condensed  Consolidated Balance Sheets as of March 31, 2005 and December 31,  2004               |   |
|                                                                                                       |   |
| Condensed  Consolidated Statements of Operations for the three months ended March 31,  2005 and 2004  |   |
|                                                                                                       |   |
| Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2005 and 2004  |   |
|                                                                                                       |   |
| Notes  to Condensed Consolidated Financial Statements                                                      |   |
|                                                                                                       |   |
| Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   |
|                                                                                                       |   |
| Item 3.  Controls and Procedures                                                                      |   |
|                                                                                                       |   |
| **PART II – OTHER  INFORMATION**                                                                 |   |
|                                                                                                       |   |
| Item  1.  Legal Proceedings                                                                           |   |
|                                                                                                       |   |
| Item 6.  Exhibits and Reports on Form 8-K                                                        |   |
|                                                                                                       |   |
| Signature  Page                                                                                            |   |

 

2

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**PART I– FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                                                                                                                         | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | **(Unaudited)**          | ** ** | **(Audited)**               | ** ** |
| **ASSETS**                                                                                                                                                                                                         |       |                     |       |                        |       |
| Current Assets:                                                                                                                                                                                                    |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                          |       | $                        | 3,791      |                        | $          | 2,315 |   |
| Short-term investments                                                                                                                                                                                             |       | 425                      |       | 75                          |       |
| Accounts receivable, less allowance for doubtful  accounts of $369 in 2005 and $508 in 2004                                                                                                                        |       | 605                      |       | 1,220                       |       |
| Inventories, net                                                                                                                                                                                                   |       | 868                      |       | 950                         |       |
| Prepaid expenses                                                                                                                                                                                                   |       | 370                      |       | 393                         |       |
| Total current assets                                                                                                                                                                                               |       | 6,059                    |       | 4,953                       |       |
| Property and equipment, net                                                                                                                                                                                        |       | 316                      |       | 299                         |       |
| Other assets                                                                                                                                                                                                       |       | 54                       |       | 64                          |       |
| TOTAL ASSETS                                                                                                                                                                                                       |       | $                        | 6,429      |                        | $          | 5,316 |   |
|                                                                                                                                                                                                               |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                      |       |                     |       |                        |       |
|                                                                                                                                                                                                               |       |                     |       |                        |       |
| Current Liabilities:                                                                                                                                                                                               |       |                     |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                                                                              |       | $                        | 1,375      |                        | $          | 1,667 |   |
| Deferred revenue                                                                                                                                                                                                   |       | 775                      |       | 799                         |       |
| Total current liabilities                                                                                                                                                                                          |       | 2,150                    |       | 2,466                       |       |
| Stockholders’ Equity:                                                                                                                                                                                         |       |                     |       |                        |       |
| Preferred stock – $.01 par value;  Authorized shares – 5,000  Series 1 shares issued and outstanding – 439 in 2005 and 840 in 2004  Liquidation preference of $2,252 as of March 31, 2005 |       | 1,553                    |       | 2,968                       |       |
| Series 2 shares issued and outstanding –  1,065  Liquidation preference of $2,664 as of March 31, 2005                                                                                              |       | 1,675                    |       | —                      |       |
| Common stock – $.01 par value; authorized shares –  80,000;  Issued shares – 6,068 in 2005 and 5,431 in 2004;  Outstanding shares – 6,058 in 2005 and 5,421 in 2004                            |       | 61                       |       | 54                          |       |
| Common stock held in treasury, at cost – 10 shares                                                                                                                                                            |       | (362                     | )          | (362                        | )          |
| Additional paid-in capital                                                                                                                                                                                         |       | 51,290                   |       | 49,095                      |       |
| Accumulated deficit                                                                                                                                                                                                |       | (49,759                  | )          | (48,732                     | )          |
| Accumulated other comprehensive loss                                                                                                                                                                               |       | (179                     | )          | (173                        | )          |
| Total  stockholders’ equity                                                                                                                                                                                   |       | 4,279                    |       | 2,850                       |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                    |       | $                        | 6,429      |                        | $          | 5,316 |   |
|                                                                                                                                                                                                                    |            |                          |            |                             |            |  |  |  |  |

 

Seeaccompanying notes.

 

3

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS(In thousands, except per share amounts)(Unaudited)

 
| ** **                                                                  | ** ** | **Three Months Ended**   | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                  | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Net product revenue                                                         |       | $                        | 871        |   | $ | 905 |   |
| Net customer support and maintenance revenue                                |       | 314                      |       | 362 |   |
| Total revenue                                                               |       | 1,185                    |       | 1,267 |   |
| Cost of product revenue                                                     |       | 501                      |       | 526 |   |
| Cost of customer support and maintenance revenue                            |       | 26                       |       | 111 |   |
| Total cost of revenue                                                       |       | 527                      |       | 637 |   |
|                                                                        |       |                     |       |   |   |
| Gross profit                                                                |       | 658                      |       | 630 |   |
|                                                                        |       |                     |       |   |   |
| Operating expenses:                                                         |       |                     |       |   |   |
| Sales and marketing                                                         |       | 759                      |       | 960 |   |
| Research and development                                                    |       | 702                      |       | 601 |   |
| General and administrative                                                  |       | 228                      |       | 264 |   |
| Severance costs                                                             |       | —                   |       | 96 |   |
|                                                                        |       |                     |       |   |   |
| Operating loss                                                              |       | (1,031                   | )          | (1,291 | ) |
|                                                                        |       |                     |       |   |   |
| Interest income, net                                                        |       | 4                        |       | 18 |   |
|                                                                        |       |                     |       |   |   |
| Loss before income tax provision                                            |       | (1,027                   | )          | (1,273 | ) |
|                                                                        |       |                     |       |   |   |
| Income tax provision                                                        |       | —                   |       | — |   |
|                                                                        |       |                     |       |   |   |
| Net loss                                                                    |       | $                        | (1,027     | ) | $ | (1,273 | ) |
|                                                                        |       |                     |       |   |   |
| Preferred stock dividends accrued                                           |       | (29                      | )          | — |   |
| Beneficial conversion feature on preferred stock                            |       | (919                     | )          | (938 | ) |
| Net loss attributable to common stockholders                                |       | $                        | (1,975     | ) | $ | (2,211 | ) |
|                                                                        |       |                     |       |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                        | (0.33      | ) | $ | (0.43 | ) |
|                                                                        |       |                     |       |   |   |
| Weighted average common shares outstanding, basic  and diluted              |       | 6,030                    |       | 5,163 |   |

 

Seeaccompanying notes.

 

4

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**INTRUSION INC. AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS(In thousands)(Unaudited)

 
| ** **                                                                      | ** ** | **Three Months Ended**   | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Operating Activities:                                                           |       |                     |       |   |   |
| Net loss                                                                        |       | $                        | (1,027     | ) | $ | (1,273 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:    |       |                     |       |   |   |
| Depreciation and amortization                                                   |       | 39                       |       | 104 |   |
| Provision for doubtful accounts                                                 |       | (100                     | )          | — |   |
| Changes in operating assets and liabilities:                                    |       |                     |       |   |   |
| Accounts receivable                                                             |       | 715                      |       | 474 |   |
| Inventories                                                                     |       | 82                       |       | (195 | ) |
| Other assets                                                                    |       | 33                       |       | 48 |   |
| Accounts payable and accrued expenses                                           |       | (310                     | )          | (314 | ) |
| Deferred revenue                                                                |       | (24                      | )          | 80 |   |
| Net cash used in operating activities                                           |       | (592                     | )          | (1,076 | ) |
| Investing Activities:                                                           |       |                     |       |   |   |
| Purchases of short-term investments                                             |       | (350                     | )          | — |   |
| Maturities of short-term investments                                            |       | —                   |       | 1,200 |   |
| Net purchases of property and equipment                                         |       | (56                      | )          | (42 | ) |
| Net cash (used in) provided by investing  activities                            |       | (406                     | )          | 1,158 |   |
| Financing Activities:                                                           |       |                     |       |   |   |
| Proceeds from the exercise of employee stock  options                           |       | —                   |       | 6 |   |
| Dividends paid on preferred stock                                               |       | (35                      | )          | — |   |
| Proceeds from the issuance of preferred stock and  warrants, net                |       | 2,515                    |       | 4,725 |   |
| Net  cash provided by financing activities                                      |       | 2,480                    |       | 4,731 |   |   |
|                                                                            |       |                     |       |   |   |
| Effect of foreign currency translation adjustment  on cash and cash equivalents |       | (6                       | )          | — |   |
|                                                                            |       |                     |       |   |   |
| Net increase in cash and cash equivalents                                       |       | 1,476                    |       | 4,813 |   |
| Cash and cash equivalents at beginning of period                                |       | 2,315                    |       | 974 |   |
| Cash and cash equivalents at end of period                                      |       | $                        | 3,791      |   | $ | 5,787 |   |
|                                                                            |       |                     |       |   |   |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING  ACTIVITIES:                      |       |                     |       |   |   |
|                                                                            |       |                     |       |   |   |
| Fair value of warrants issued in connection with  sale of preferred stock       |       | $                        | 815        |   | $ | 1,191 |   |
| Amortization of preferred stock beneficial  conversion feature                  |       | $                        | (919       | ) | $ | (938 | ) |
| Preferred stock dividend accrued                                                |       | $                        | 29         |   | $ | — |   |
| Preferred stock financing costs accrued                                         |       | $                        | 25         |   | $ | — |   |
| Conversion of preferred stock to common stock                                   |       | $                        | 1,415      |   | $ | — |   |
|                                                                                 |            |                          |            |  |  |  |  |  |  |  |

 

Seeaccompanying notes.

 

5

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**INTRUSION INC. AND SUBSIDIARIES**

NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.          Description of Business

 

Wedevelop, market and support a family of regulated information compliance anddata privacy protection products, entity identification systems along withnetwork intrusion prevention and detection systems that address vital securityissues facing organizations with mission critical business applications orhousing classified, confidential, or customer information assets.  Wecurrently provide network security and regulated information compliancesolutions with our Compliance CommanderTM for regulated information and dataprivacy protection, TraceCopTM identification and location service, SpySnareTMfor real-time inline blocking of spyware and unwanted peer-to-peer applicationsand SecureNetTM for network intrusion prevention and detection.

 

We market and distribute ourproducts through a direct sales force to end-users and distributors and bynumerous domestic and international system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include high technology, manufacturing, telecommunications,retail, transportation, health care, insurance, entertainment, utilities andenergy companies, government entities, financial institutions, and academicinstitutions.

 

We were organized in Texasin September 1983 and reincorporated in Delaware in October 1995.  For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks.  On April 17, 2000, weannounced plans to sell, or otherwise dispose of, our networking divisions,which included our Essential Communications division and our local areanetworking assets.  In accordance with theseplans, we have accounted for these businesses as discontinued operations.  On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ tickersymbol from ODSI to INTZ to reflect our focus on intrusion detectionsolutions.  On November 1, 2001, wechanged our name from Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400. Our website URL is www.intrusion.com. Information contained in or linked to our website are not a part of thisreport.  References to “we,” “us” and “our”in this report refer to Intrusion Inc. and its subsidiaries.

 

As of March 31, 2005,we had cash, cash equivalents and short-term investments in the amount ofapproximately $4.2 million, up from approximately $2.4 million as of December 31,2004.  Although we believe we havesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, based on our internal estimates andour operating plan, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  Moreover, despiteactions to reduce our costs and improve our profitability, we expect ouroperating losses and net operating cash outflows to continue through at leastthe first half of 2005.  As a result, wemay not be able to achieve the revenue and gross margin objectives necessary toachieve positive cash flow or profitability or to remain in compliance withNasdaq’s continued listing requirement of at least $2.5 million of stockholders’equity without obtaining additional financing. We do not currently have any arrangements for financing and we may notbe able to secure additional debt or equity financing on terms acceptable tous, or at all, at the time when we need such funding.  If our business does not generate sufficientcash flow from operations and sufficient future financings are not available,we may not be able to operate or grow our business, pay our expenses when due,fund our other liquidity needs or maintain our listing on the Nasdaq SmallCapMarket.

 

OnMarch 28, 2005, we completed a $2.7 million private placement of our Series 25% Convertible Preferred Stock and warrants. In the private placement, we sold 1,065,200 shares of preferred stock ata price of $2.50 per share for gross proceeds of $2.7 million, less $173,000 ofissuance costs.  The preferred shares maybe converted into 1,065,200 shares of common stock.  Included in this transaction were warrants topurchase 532,600 shares of common stock at an exercise price of $2.77 pershare.  In connection with the closing ofthis private placement, we issued warrants to purchase an aggregate of 60,390shares of our common stock at an exercise price of $2.77 per share to twoaffiliates of our financial advisor for assistance with the private placement.

 

6

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2.          Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-QSB and Article 10of Regulation S-B.  Accordingly, they donot include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2004balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three months ending March 31,2005 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The condensed consolidated financial statements included herein shouldbe read in conjunction with the consolidated financial statements and notesthereto included in the Company’s annual report on Form 10-KSB forthe year ended December 31, 2004.

 

3.          Inventories (In thousands)

 
| ** **              | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------|------------|-------------------------|------------|----------------------------|------------|
|                    |       |                    |       |                       |       |
| Inventories consist of: |       |                    |       |                       |       |
|                    |       |                    |       |                       |       |
| Finished goods          |       | $                       | 649        |                       | $          | 743 |   |
| Work in progress        |       | 60                      |       | 18                         |       |
| Demonstration systems   |       | 159                     |       | 189                        |       |
| Net inventory           |       | $                       | 868        |                       | $          | 950 |   |

 

4.          Accounting for Stock-Based Compensation

 

We account for employeestock-based compensation in accordance with APB 25.  The following table summarizes relevantinformation as to the reported results under our intrinsic value method ofaccounting for stock awards, with supplemental information as if the fair valuerecognition provision of SFAS 123 as amended by SFAS 148 had been applied forthe quarters ended March 31, 2005 and March 31, 2004 (in thousands,except per share data).

 
| ** **                                                                                      | ** ** | **Quarter  Ended  March 31, 2005** | ** ** | **Quarter  Ended  March 31, 2004** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
|                                                                                            |       |                                    |       |                                    |       |
| Net loss attributable to common  stockholders                                                   |       | $                                       | (1,975     | )                                       | $          | (2,211 | ) |
| Deduct: Total stock-based compensation  determined under fair value-based method for all awards |       | (131                                    | )          | (72                                     | )          |
| Pro forma net loss attributable to common  stockholders                                         |       | $                                       | (2,106     | )                                       | $          | (2,283 | ) |
| Net loss per share attributable to common  stockholders:                                        |       |                                    |       |                                    |       |
| as reported (basic and diluted)                                                                 |       | $                                       | (0.33      | )                                       | $          | (0.43 | ) |
| pro forma (basic and diluted)                                                                   |       | $                                       | (0.35      | )                                       | $          | (0.44 | ) |
| Weighted-average shares used in  computation:                                                   |       |                                    |       |                                    |       |
| Basic and diluted                                                                               |       | 6,030                                   |       | 5,163                                   |       |

 

7

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As required, the pro formadisclosures above include options granted since January 1, 1995.  Consequently, the effects of applying SFAS123 and SFAS 148 for providing pro forma disclosures may not be representativeof the effects on reported operating results for future years until all optionsoutstanding are included in the pro forma disclosures.  For purposes of pro forma disclosures, theestimated fair value of stock-based compensation plans and other options areamortized to expense primarily over the vesting period.

 

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS 123 and supersedes APB Opinion No. 25.SFAS 123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values. The pro forma disclosures previously permitted under SFAS123 no longer will be an alternative to financial statement recognition. Forthe Company, SFAS 123R is effective for periods beginning after December 15,2005. Early application of SFAS 123R is encouraged, but not required. We planto adopt SFAS 123R on January 1, 2006 using the modified prospectiveapplication method described in the statement. Under the modified prospectiveapplication method, we will apply the standard to new awards and to awardsmodified, repurchased, or cancelled after the required effective date.Additionally, compensation cost for the unvested portion of awards outstandingas of the required effective date will be recognized as compensation expense asthe requisite service is rendered after the required effective date.

 

Weare evaluating the impact of adopting SFAS 123R and expect that we will recordsubstantial non-cash stock compensation expenses. The adoption of SFAS 123R isnot expected to have a significant effect on our financial condition or cashflows but is expected to have a significant, adverse effect on our results ofoperations.  The future impact of theadoption of SFAS 123R cannot be predicted at this time because it will dependon levels of share-based payments granted by us in the future.  However, had we adopted SFAS 123R in priorperiods, the impact of that standard would have approximated the impact of SFAS123 as described in the disclosure of pro forma net loss attributable to commonstockholders included above.

 

5.          Net Loss Per Share

 

Basic net loss per share iscomputed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and common stock equivalents outstandingfor the period.  Our common stockequivalents include all common stock issuable upon conversion of convertiblepreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation for the three-monthperiods ended March 31, 2005 and 2004 are 3,656,866 and 2,609,175,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three-monthperiods ended March 31, 2005 and 2004, as they are antidilutive.

 

6.          Commitments and Contingencies

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of those matterswill have a material adverse affect on our consolidated financial position,operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

7.          Preferred Stock PrivatePlacement

 

On March 28, 2005,we completed a $2.7 million private placement of Series 2 5% ConvertiblePreferred Stock and warrants.  In theprivate placement, we sold 1,065,200 shares of preferred stock at a price of$2.50 per share for gross proceeds of $2.7 million, less $173,000 of issuancecosts.  The shares of Series 2 5%preferred stock are convertible into 1,065,200 shares of common stock at aninitial conversion price of $2.50 per share. Holders of the Series 2 5% preferred stock include 160,000 sharespurchased by our CEO and 60,000 shares purchased by a director of the Company.

 

The 5% dividends accruingon the Series 2 5% preferred stock are required to be paid quarterly onthe first business day in March, June, September and December of eachyear, beginning with June 2005.  Theliquidation preference for the preferred stock is an amount equal to $2.50 pershare plus any accrued and unpaid dividends. Holders of our Series 2 preferred stock have liquidation preferencerights over our other 5% preferred stock holders as well as our common stockholders.  The holders of the Series 25% preferred stock are not entitled to vote on any matter, except as otherwiserequired by law or with respect to certain limited matters specified in theCertificate of Designations creating the Series 2 5% preferred stock.

 

8

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Included in thistransaction were warrants to purchase 532,600 shares of common stock at anexercise price of $2.77 per share.  Warrantholders include 80,000 held by our CEO and 30,000 held by a director of theCompany.  The relative fair value of thesewarrants was valued at $0.7 million using the Black-Scholes model and has beenrecorded as a discount to the Series 2 5% Preferred Stock and an increasein additional paid-in capital.  Theissuance of these warrants also resulted in a beneficial conversion feature tothe Series 2 5% preferred stock valued at $0.9 million.  In accordance with EITF 98-5, thebeneficial conversion feature was fully amortized in the first quarter of 2005,as the preferred stock does not have a stated maturity and is immediatelyconvertible into common stock.  Thisbeneficial conversion feature is added to the net loss to arrive at the netloss attributed to common stockholders. In connection with the closing of this private placement, we issuedwarrants to purchase 60,390 shares of our common stock at an exercise price of$2.77 per share to two affiliates of our financial advisor for assistance withthe private placement.  These warrantswere valued at $0.1 million using the Black-Scholes model and have beenrecorded as a discount to the Series 2 5% Preferred Stock and an increaseto additional paid-in capital.

 

The Series 2 5%preferred stock was recorded as the net of the proceeds of $2.7 million less$173,000 issuance costs and the fair value of the warrants issued in conjunctionwith the Series 2 5% preferred stock totaling $0.8 million.

 

Holders of Series 25% preferred stock have the right to require us redeem any or all of the theirshares upon the occurrence of certain events within the Company’s control thatare defined in Certificate of Designation at a price equal the sum of (1) thegreater of $3.25****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.50 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 25% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 2 5% preferred stock.

 

8.          Common Stock

 

During the three monthsended March 31, 2005, 400,608 shares of our 5% preferred stock wereconverted into 637,102 shares of common stock. In addition, an employee exercised stock options to purchase 167 sharesof common stock.

 

9.          Comprehensive Income(Loss)

 

SFAS No. 130,Reporting Comprehensive Income, establishes standards for the reporting anddisplay of comprehensive income (loss) and its components.  SFAS No. 130 requires, among otherthings, that foreign currency translation adjustments be included in othercomprehensive income (loss).  Thefollowing statement presents comprehensive income (loss) for the three monthsended March 31, 2005 and 2004 (in thousands):

 
| ** **                              | ** ** | **Three Months Ended   March 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                              | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Net loss                                |       | (1,027                                  | )          | (1,273 | ) |
| Other comprehensive income (loss):      |       |                                    |       |   |   |
| Foreign currency translation adjustment |       | 6                                       |       | — |   |
| Comprehensive income (loss)             |       | (1,021                                  | )          | (1,273 | ) |

 

9

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Item2.                                MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price and our ongoing Nasdaq eligibility, the highlycompetitive market for our products, the effects of sales and implementationcycles for our new products on our quarterly results, difficulties inaccurately estimating market growth, the consolidation of the informationsecurity industry, the impact of changing economic conditions, businessconditions in the information security industry, our ability to manageacquisitions effectively, our ability to manage discontinued operationseffectively, the impact of market peers and their products as well as risksconcerning future technology and others identified in our Annual Report on Form 10-KSBand other Securities and Exchange Commission filings.  Such forward-looking statements are generallyaccompanied by words such as “plan,” “estimate,” “expect,” “believe,” “should,”“would,” “could,” “anticipate,” “may” or other words that convey uncertainty offuture events or outcomes.  Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of1995.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporatesby reference certain factors that could cause actual future results of thecompany to differ materially from these statements.

 

Critical Accounting Policiesand Estimates

 

Management’s discussion andanalysis of financial condition and results of operations are based upon ourcondensed consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our condensed consolidated financialstatements.

 

*RevenueRecognition*

 

We generally recognizeproduct revenue upon shipment of product. We accrue for estimated warrantycosts and sales returns at the time of shipment based on our experience.Revenue from maintenance contracts is deferred and recognized over thecontractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, our warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  If our warranty costs exceed ourexpectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  We believe that our revenue recognitionpolicy does not include significant or subjective estimates.

 

We recognize softwarerevenue from the licensing of our software products in accordance withStatement of Position (“SOP”) No. 97-2 “Software Revenue Recognition”,SOP 98-9 “Modification of 97-2, Software Revenue Recognition, withrespect to certain transactions” and Staff Accounting Bulletin (“SAB”) No. 104,“Revenue Recognition” whereby revenue from the licensing of our products is notrecognized until all four of the following have been met: (1) execution ofa written agreement; (2) delivery of the product has occurred; (3) thefee is fixed and determinable; and (4) collectibility is probable. Bundledhardware and perpetual software product sales are recognized at time ofdelivery, as our licenses are not sold on a subscription basis.  In the case of multiple product and servicesales, we perform a Vendor Specific Objective Evidence analysis toappropriately determine the amount of revenue derived from eachdeliverable.  If our license strategychanges and we begin to offer licenses on a subscription basis, we wouldperform this analysis in a similar manner. Under these circumstances, the revenue related to the license would berecognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

 

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We have signed distributionagreements with distributors in the United States, Europe and Asia. In general,these relationships are non-exclusive. Distributors typically maintain aninventory of our products. Under these agreements, we provide certainprotection to the distributors for their inventory of our products for pricereductions as well as products that are slow moving or have been discontinuedby us.  Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care, custodyor control over the inventory, we recognize the trade accounts receivable andreduce inventory related to the sale at the time of shipment to thedistributor. Revenue, offset by deferred cost of sales, is included in deferredrevenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in our obsolescenceand slow-moving analysis and are written down according to their currentvalue.  This transaction, effectivelyrecognizes expense for the write-down, if any, and increases the net liabilityin the deferred revenue account.

 

We generally recognizeservice revenue upon delivery of the contracted service.  Service revenue, primarily includingmaintenance, training and installation are recognized upon delivery of theservice and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

 

*Allowancefor Doubtful Accounts and Returns*

 

Trade accounts receivableare stated at the amount we expect to collect. We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments.  Management considers the following factorswhen determining the collectibility of specific customer accounts:  customer credit-worthiness, past transactionhistory with the customer, current economic industry trends, and changes incustomer payment terms.  Our receivablesare uncollateralized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, adversely affecting their ability to make payments,additional allowances would be required. Based on management’s assessment, we provide for estimated uncollectibleamounts through a charge to earnings and a credit to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to accountsreceivable.  Historically, our estimatesfor sales returns and doubtful accounts have not materially differed from actualresults.

 

*Inventory*

 

We write down our inventoryfor estimated obsolescence or unmarketable inventory equal to the differencebetween the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, additionalinventory write-downs may be required. Historically, our estimates for inventory obsolescence have not differedmaterially from actual results.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                        | ** ** | **Three Months Ended**   | ** ** |
|---------------------------------------------------|------------|--------------------------|------------|
| ** **                                        | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Net product revenue                               |       | 73.5                     | %          | 71.4 | % |
| Net customer support and maintenance  revenue     |       | 26.5                     |       | 28.6 |   |
| Total revenue                                     |       | 100.0                    |       | 100.0 |   |
| Cost of product revenue                           |       | 42.3                     |       | 41.5 |   |
| Cost of customer support and maintenance  revenue |       | 2.2                      |       | 8.8 |   |
| Total cost of revenue                             |       | 44.5                     |       | 50.3 |   |
| Gross profit                                      |       | 55.5                     |       | 49.7 |   |
| Operating expenses:                               |       |                     |       |   |   |
| Sales and marketing                               |       | 64.1                     |       | 75.8 |   |
| Research and development                          |       | 59.2                     |       | 47.4 |   |
| General and administrative                        |       | 19.2                     |       | 20.8 |   |
| Severance costs                                   |       | —                   |       | 7.6 |   |
| Operating loss                                    |       | (87.0                    | )          | (101.9 | ) |
|                                              |       |                     |       |   |   |
| Interest income, net                              |       | 0.3                      |       | 1.4 |   |
| Loss before income tax provision                  |       | (86.7                    | )          | (100.5 | ) |
|                                              |       |                     |       |   |   |
| Income tax provision                              |       | —                   |       | — |   |
|                                              |       |                     |       |   |   |
| Net loss                                          |       | (86.7                    | )%         | (100.5 | )% |
| Preferred stock dividends accrued                 |       | (2.4                     | )          | — |   |
| Beneficial conversion feature on preferred  stock |       | (77.6                    | )          | (74.0 | ) |
|                                              |       |                     |       |   |   |
| Net loss attributable to common  stockholders     |       | (166.7                   | )%         | (174.5 | )% |

 
| ** **          | ** ** | **Three Months Ended**   | ** ** |
|---------------------|------------|--------------------------|------------|
| ** **          | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
| Domestic revenues   |       | 86.1                     | %          | 67.5 | % |
| Export revenues to: |       |                     |       |   |   |
| Europe              |       | 7.6                      |       | 24.8 |   |
| Canada              |       | 0.1                      |       | 2.6 |   |
| Asia                |       | 6.1                      |       | 5.1 |   |
| Latin America       |       | 0.1                      |       | — |   |
|                |       |                     |       |   |   |
| Net revenues        |       | 100.0                    | %          | 100.0 | % |

 

**NetRevenues**.  Net revenues for the quarter ended March 31,2005 were $1.2 million, compared to $1.3 million for the same period in2004.  Product revenues remained constantat $0.9 million for the quarter ended March 31, 2005 compared to the sameperiod in 2004.  Customer support andmaintenance revenue decreased $0.1 million for the quarter ended March 31,2005 compared to the same period in 2004. Total revenues (including maintenance and support) for the quarter endedMarch 31, 2005 from our SecureNet product line decreased slightly $0.1million from $1.2 million to $1.1 million when compared to the same period in2004.  Our first generation productsales, including PDS and SecureCom remained constant at $0.1 million for thequarter ended March 31, 2005.  Inaddition to our shift in business focus, continued sluggish economic conditionsand delayed customer orders contributed to the decline in revenues.

 

**ExportRevenues**.  Export revenues for the quarter ended March 31,2005 decreased to $0.2 million from $0.4 million compared to the same period in2004 as revenues from our PDS security appliance family, which dominated oursales internationally, decreased and we focused more of our resourcesdomestically.

 

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**Concentrationof Revenues**.  Revenues from sales to various U.S.government entities totaled $0.7 million, or 62.8% of revenues, for the quarterended March 31, 2005 compared to $0.4 million, or 34.5% of revenues, forthe same period in 2004.  Revenues from agovernment reseller, Concurrent Technologies Corporation, which are included inrevenues to U.S. government entities, were $0.3 million, or 24.1% of revenues,for the quarter ended March 31, 2005 compared to $0.3 million, or 20.0% ofrevenues, for the same period in 2004. Revenues from Expedia Inc. were $20 thousand, or 1.7% of revenues, forthe quarter ended March 31, 2005 compared to $0.1 million, or 11.5% ofrevenues, for the same period in 2004. Although, we expect our concentration of revenues to vary amongcustomers in future quarters depending upon the timing of certain sales, weanticipate that sales to government customers will continue to account for asignificant portion of our revenues in future quarters.

 

**GrossProfit**.  Gross profit was $0.7 million or 55.5% of netrevenues for the quarter ended March 31, 2005, compared to $0.6 million or49.7% of net revenues for the quarter ended March 31, 2004. Gross profitmargins as a percentage of net revenues increased from the same period in theprior year due to a continued shift in product mix, which resulted in anincrease as a percentage of revenues of our higher margin SecureNet productline.  Gross profit on product revenuesfor the quarters ended March 31, increased from 42.0% in 2004 to 42.5% in2005 due to the continued transition to our higher margin software-based products.  Gross profit on customer support andmaintenance revenues for the quarters ended March 31, increased from 69.3%in 2004 to 91.7% in 2005, as less repair costs were incurred during the 2005quarter in conjunction with our transition to software-based products.

 

Gross profit as a percentageof net revenues is impacted by several factors, including shifts in productmix, changes in channels of distribution, revenue volume, fluctuations inthird-party assembly costs, pricing strategies, and fluctuations in revenues ofintegrated third-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreased to$0.8 million for the quarter ended March 31, 2005, compared to $1.0million for the quarter ended March 31, 2004. This cost reduction was primarilydue to cost reduction initiatives.  Salesand marketing expenses may vary as a percentage of net sales in thefuture.  However, we believe that thesecosts will remain relatively constant through the end of the year.

 

**Researchand Development**.  Research and development expenses increasedto $0.7 million for the quarter ended March 31, 2005, compared to $0.6million for the quarter ended March 31, 2004. Research and developmentcosts are expensed in the period incurred. Research and development expenses increased for the quarter ended March 31,2005, compared to the same period in 2004 as a higher percentage of ourengineers were engaged on revenue generating projects during the quarter ended March 31,2004 and their associated costs were recognized as direct product costs relatedto those projects.  During the quarterended March 31, 2005, a higher percentage of our engineers were engaged indevelopment activities and their costs are accurately reflected in the researchand development section of the statement of operations.  Research and development expenses may vary asa percentage of net sales in the future.

 

**General andAdministrative**.  General and administrative expenses decreasedto $0.2 million for the quarter ended March 31, 2005, compared to $0.3million for the quarter ended March 31, 2004.  This decrease was primarily due to costreduction initiatives employed during the quarter.  It is expected that general andadministrative expenses will remain relatively constant throughout the remainderof the year, as no further headcount reductions or additions areanticipated.  General and administrativeexpense may vary as a percentage of net sales in the future.

 

**SeveranceCosts. **No severance costs were incurred during thequarter ended March 31, 2005. Severance costs were $0.1 million for the quarter ended March 31,2004.  Severance costs during the quarterended March 31, 2004 consisted primarily of severance payments made duringthe period as a result of reductions in force. All severance obligations were paid prior to March 31, 2004, and wedid not receive further benefit from these individuals after March 31,2004.

 

**Interest**.  Netinterest income decreased to $4 thousand for the quarter ended March 31,2005 compared to $18 thousand for the same period in 2004.  The decrease in interest income was primarilydue to the decrease of approximately $2.1 million in overall cash andshort-term investment balances over the prior year.  In addition, the average rate of returndecreased when comparing the quarter ended March 31, 2004 to the quarterended March 31, 2005.  Net interestincome may vary in the future based on our cash flow and rate of return oninvestments.

 

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Liquidity and CapitalResources

 

Our principal source ofliquidity at March 31, 2005 is approximately $3.8 million of cash and cashequivalents and $0.4 million of short-term investments.  At March 31, 2005 working capital was$3.9 million compared to $5.9 million at March 31, 2004.

 

Cash used in operations forthe three months ended March 31, 2005 was $0.6 million, primarily due toan operating loss of $1.0 million, a decrease in accounts payable and accruedexpenses of $0.3 million and a decrease in the provision for doubtful accountsof $0.1 million.  This cash usage waspartially offset by depreciation and amortization of $39 thousand, a decreasein accounts receivable of $0.7 million, a decrease in inventories of $0.1million and a decrease in other assets of $33 thousand.  Cash used in operations of $1.1 million forthe three months ended March 31, 2004, was primarily due to an operatingloss of $1.3 million, a decrease in accounts payable and accrued expenses of$0.3 million and an increase in inventories of $0.2 million.  This cash usage was partially offset bydepreciation expense of $0.1 million, a decrease in accounts receivable of $0.5million and other assets of $48 thousand and an increase in deferred revenue of$0.1 million.  Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including quarterly sales, our strategy in buildinginventory in advance of receiving orders from customers, and the accuracy ofour forecasts of product demand and component requirements.  In addition, during the second quarter of2005, we will be required to pay cash dividends on our 5% preferred stock and Series 25% preferred stock totaling $56 thousand. These dividends are accrued at March 31, 2005 and will be paidduring the second quarter of 2005.

 

Cash used in investingactivities in the three months ended March 31, 2005 was $0.4 million,which consisted primarily of the net purchase of short-term investments of $0.3million and net purchases of property and equipment of $0.1 million, comparedto cash provided by investing activities of $1.2 million for the three monthsended March 31, 2004, which consisted primarily of the maturity ofshort-term investments of $1.2 million, partially offset by net purchases ofproperty and equipment of $41 thousand.

 

Cash provided by financingactivities in the three months ended March 31, 2005 was $2.5 million,consisting of net financing proceeds from a private placement of $2.5 million,partially offset by payment of dividends on preferred stock of $35 thousand.

 

At March 31, 2005, theCompany did not have any material commitments for capital expenditures.

 

During the three monthsended March 31, 2005, the Company funded its operations through financingproceeds raised during the first quarter of 2005 as well as use of cash, cashequivalents and sales of short-term investments.

 

Based on our financialprojections, we expect that our cash on hand, along with our short-terminvestments, and cash from our operations will be sufficient to fund our operationsfor the next 12 months.  However, ourprojections are dependent upon our ability to meet our revenue and gross profittargets.  We funded our operations andmet our cash requirements during the quarter through financing proceeds onpreferred stock and the use of cash, cash equivalents and sales of short-terminvestments.  Although we believe we havesufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months, based on our internal estimates and ouroperating plan, the sufficiency of our cash resources may depend to a certainextent on general economic, financial, competitive or other factors beyond ourcontrol.  Moreover, despite actions toreduce our costs and improve our profitability, we expect our operating lossesand net operating cash outflows to continue through at least the first half of2005.  As a result, we may not be able toachieve the revenue and gross margin objectives necessary to achieve positivecash flow or profitability or to remain in compliance with Nasdaq’s continuedlisting requirement of at least $2.5 million of stockholders’ equity withoutobtaining additional financing.  We donot currently have any arrangements for financing, and we may not be able tosecure additional debt or equity financing on terms acceptable to us, or atall, at the time when we need such funding. If our business does not generate sufficient cash flow from operationsand sufficient future financings are not available, we may not be able tooperate or grow our business, pay our expenses when due, fund our otherliquidity needs or maintain our listing on the Nasdaq SmallCap Market.

 

We intend to explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional securitytechnologies, which we may wish to develop, either internally or through thelicensing, or acquisition of products from third parties.  While we engage from time to time in discussionswith respect to potential acquisitions, there can be no assurances that anysuch acquisitions will be made or that we will be able to successfullyintegrate any acquired business.  Inorder to finance such acquisitions and working capital it may be necessary forus to raise additional funds through public or private financings.  Any equity or debt financings, if availableat all, may be on terms, which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders.

 

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Factors That May AffectFuture Results of Operations 

 

Numerous factors may affectour business and future results of operations. These factors include current economic and market conditions, the effectof military actions on government and corporate spending on informationsecurity products, spending patterns of, and appropriations to, U.S. governmentdepartments, technological changes, competition and market acceptance,acquisitions, product transitions, timing of orders, manufacturing andsuppliers, reliance on outsourcing vendors and other partners, intellectualproperty and licenses, third-party products, dependence on governmentcustomers, international operations, intellectual property issues, liquidityand cash resources and effects of restructuring plans and cost reductions.  The discussion below addresses some of theseand other factors.  For a more thoroughdiscussion of these and other factors that may affect our business and futureresults, see the discussion under the caption “Factors That May AffectFuture Results of Operations” in our Annual Report on Form 10-KSBfor the year ended December 31, 2004.

 

***Our cash, cash equivalents, and investments have increasedapproximately $1.8 million in the last three months but have generally declinedsince 2003.  As a result of our expectedcontinuing net cash outflows, we may not have sufficient cash to operate ourbusiness and may not be able to maintain our Nasdaq listing.***

 

During the three monthsended March 31, 2005, our cash, cash equivalents and short-terminvestments increased approximately $1.8 million from approximately $2.4million as of December 31, 2004 to approximately $4.2 million at March 31,2005, primarily as a result of a private placement of our preferred stock andwarrants, that yielded net proceeds of $2.5 million, which we completed on March 28,2005.  As of December 31, 2004, wehad cash, cash equivalents and investments in the amount of approximately $2.4million, down from approximately $2.7 million as of December 31,2003.  Although we believe the proceedswe received in connection with the private placement in March 2005 willprovide us with sufficient cash resources to finance our operations for thenext twelve months, based on our internal estimates and our operating plan, thesufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control. Moreover,despite our actions to reduce costs and improve profitability, we expect ournet operating losses and net operating cash outflows to continue through atleast the first half of 2005.  If ourlosses continue, our stockholders’ equity could fall below $2.5 million in thefourth quarter of 2005.  If this occurs,we would not be in compliance with the Nasdaq listing requirements, and wecould face delisting.  We do notcurrently have any further arrangements for financing, and we may not be ableto secure additional debt or equity financing on terms that are acceptable tous, or at all, at the time when we need this financing.  Therefore, if our business does not generatesufficient cash flow from operations and sufficient financing resources are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due, fund our other liquidity needs or maintain our listing on the NasdaqSmallCap Market.

 

***If we fail to respond to rapid technological changes in the networksecurity and data protection industries, we may lose customers or our productsmay become obsolete.***

 

The network security anddata protection industries are characterized by frequent product introductions,rapidly changing technology and continued evolution of industry standards.  We must introduce upgrades to our productsrapidly in response to customer needs, such as new computer viruses or othernovel external attacks on computer networks. In addition, the nature of the network security and data protectionindustries requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our products thatmeet changing customer requirements and evolving industry standards. Thedevelopment of technologically advanced network security and data protection productsis a complex and uncertain process requiring high levels of innovation, rapidresponse and accurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or enhanced productssuccessfully in a timely manner. Further, we or our competitors may introduce new products or productenhancements that shorten the life cycle of our existing products or cause ourexisting products to become obsolete.

 

***Our revenues have declined from $6.5 million in 2003 to $6.0 million in2004 and to $1.2 million for the three months ended March 31, 2005 from$1.3 million for the same period in 2004 in connection with a shift to sales ofour newer product lines. If our network intrusion detection, regulatedinformation compliance system, data privacy system and spyware preventionproducts do not achieve market acceptance, our revenues will suffer.***

 

Over the past three years,we have transitioned our sales strategy from our lower margin SecureCom and PDSsecurity appliance products to the development and sales of our higher marginnetwork intrusion detection, regulated information compliance system, dataprivacy protection and spyware prevention products.  During this transition, sales of our newproducts were not enough to counteract the loss in sales associated with ourolder products.  As a result, our netrevenues have declined from approximately $7.8 million in 2002, toapproximately $6.5 million in 2003 and approximately $6.0 million in 2004.  In addition, our revenues for the first threemonths of 2005 are $1.2 million as compared to $1.3 million for the same periodin 2004.

 

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Our new network securityproducts, regulated information compliance systems, data privacy protectionsystems and spyware prevention products have only been in the market place fora limited period of time and may have longer sales cycles than our previousproducts.  Although response to ourproducts has been positive, we have not yet received broad marketacceptance.  We cannot assure you thatour present or future products will achieve market acceptance on a sustainedbasis.

 

In order to achieve marketacceptance and achieve future revenue growth, we must introduce complementarysecurity and data protection products, incorporate new technologies into ourexisting product lines and design, develop and successfully commercializehigher performance products in a timely manner. We cannot assure you that we will be able to offer new or complementaryproducts that gain market acceptance quickly enough to avoid decreased revenuesduring current or future product introductions or transitions.

 

***We resemble a developmental stage company and our business strategy maynot be successful.***

 

From our founding in 1983until 2000, we derived substantially all of our revenue from the design,manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, on April 17,2000, we announced our plans to sell our local area networking assets andrelated networking divisions.

 

As a result of these sales,we now depend exclusively on revenues generated from the sale of our networksecurity products, which have received limited market acceptance.  Moreover, we have only recently introducedour regulated compliance and data privacy systems and our spyware preventionproducts.  Although initial response tothese products has been positive, the market for these products has only begunto emerge and sales of these products may not occur as quickly as weexpect.  Consequently, we resemble adevelopmental stage company and will face the following inherent risks anduncertainties:

 

•                  the need for our network security products,regulated information compliance systems, data privacy protection systems andspyware prevention products to achieve market acceptance and produce asustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptableterms; and

 

•                  our ability to offer greater value than ourcompetitors.

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products and regulated information compliance systems, our business,financial condition and operating results would be materially adverselyaffected.

 

***We incurred a net loss of $1.0 million for the three months ended March 31,2005 and have an accumulated deficit of $49.8 million as of March 31,2005.  As a result, we must generatesubstantially greater revenues from sales in order to achieve profitability.***

 

We have incurred significantoperating losses and are uncertain about our future operating results.  For the three months ended March 31,2005, we incurred a net loss of $1.0 million and had an accumulated deficit ofapproximately $49.8 million as of March 31, 2005.  In addition, our revenues have declined from$7.8 million in 2002, to $6.5 million in 2003, and $6.0 million in 2004.  We need to generate and sustain substantiallygreater revenues from the sales of our products if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue indefinitely, and wemay never achieve or sustain profitability or generate positive cash flow.

 

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***We face intense competition from both start-up and establishedcompanies that may have significant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principle competitors inthe network intrusion and detection market include Internet Security Systems, Inc.,Cisco Systems, Inc., Symantec, Inc., Netscreen Technologies, Inc.,McAfee, Inc., Tipping Point Technologies, a division of 3COM Corporation,and NFR Security, Inc.  The marketfor regulated information compliance systems is relatively new.  Our competitors in this market include anumber of start-up companies that have entered the market in the last twoyears.  However, as this market develops,we expect increased competition from both start-up and establishedcompanies.  Our current and potentialcompetitors may have one or more of the following significant advantages overus:

 

•               greater financial, technical and marketingresources;

 

•                  better name recognition;

 

•                  more comprehensive security solutions;

 

•                  better or more extensive cooperativerelationships; and

 

•                  larger customer base.

 

Although we believe ournetwork security products and regulated information compliance systems comparefavorably to our competitors’ products and create a sustainable business model,we cannot assure you that our products will achieve market acceptance or thatwe will be able to compete successfully with our existing or new competitors.

 

***Military actions may disrupt our business by reducing spending ourproducts, increasing our costs and affecting our international operations.***

 

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

 

•              reducing or delaying government or corporatespending on network security products;

 

•              increasing the cost and difficulty inobtaining materials or shipping products; and

 

•               affecting our ability to conduct businessinternationally.

 

Should these events occur,our business, operating results and financial condition could be materially andadversely affected.

 

***Our products can have long sales and implementation cycles, which mayresult in us incurring substantial expenses before realizing any associatedrevenues.***

 

The sale and implementationof our products to large companies and government entities typically involves alengthy education process and a significant technical evaluation and commitmentof capital and other resources.  Thisprocess is also subject to the risk of delays associated with customers’internal budgeting and other procedures for approving capital expenditures,deploying new technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer. Our quarterly and annual operating results could be materially harmed iforders forecasted for a specific customer for a particular period are not realized.

 

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***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

 

During the first threemonths of 2005, we did not have any restructuring costs.  However, since we began restructuring in2002, we have incurred approximately $1.0 million in restructuring charges,severance, and related expenses. The objective of our restructuring plan was toreduce our cost structure to a sustainable level that is consistent with ourcurrent cash resources and the general economic climate.  We have also implemented other strategicinitiatives to strengthen our operations, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

***Consolidation in the network security and data protection industriesmay limit market acceptance of our products.***

 

Several of our competitorshave acquired security companies with complementary technologies in the past,and we expect consolidation in the network security industry to continue in thefuture.  These acquisitions may permitour competitors to accelerate the development and commercialization of broaderproduct lines and more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companies withwhich we have a strategic relationship by our competitors may limit our accessto commercially significant technologies. Further, business combinations in the network security industry arecreating companies with larger market share, customer bases, sales forces,product offerings and technology and marketing expertise, which may make itmore difficult for us to compete.

 

***Sales to government entities accounted for 62.8% of our revenues thethree months ended March 31, 2005 and 53.6% of our revenues for the yearended December 31, 2004.  Sales togovernment customers involve unique risks, which could adversely impact ourrevenues.***

 

We derived 62.8% of ourrevenues from sales to various U.S. government entities for the three monthsended March 31, 2005, and 53.6% of our revenues from these sales for theyear ended December 31, 2004.  Weexpect to continue to derive a substantial portion of our revenues from U.S.government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding, qualificationrequirements, delays or changes in funding, budgetary constraints, politicalagendas, extensive specification development and price negotiations andmilestone requirements.  Each governmententity also maintains its own rules and regulations with which we mustcomply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

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***We derived 13.9% of our revenues from international sales in the threemonths ended March 31, 2005, and 19.2% of our revenues from these salesfor the year ended December 31, 2004. Our ability to sell our products internationally are subject to certainrisks which could harm our business.***

 

Sales to foreign customersaccounted for approximately 19.2% of our revenues for the year ended December 31,2004, and 32.5% of our revenues for the three months ended March 31,2004.  Although export sales decreased to13.9% of our revenues for the quarter ended March 31, 2005, we expectsales to foreign customers to continue to represent a significant portion ofour revenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

 

•                  political, social and economic instability;

 

•                  trade restrictions;

 

•                  increases in duty rates and other potentiallyadverse tax consequences;

 

•                  exposure to different legal standards,particularly with respect to the protection of intellectual property;

 

•                  burdens of complying with a variety offoreign laws;

 

•                  unexpected changes in regulatoryrequirements;

 

•                  import and export license requirements andrestrictions of the United States and each other country where we operate;

 

•                  fluctuations in currency exchange rates; and

 

•                  changes in local purchasing practices,including seasonal fluctuations in demand.

 

***Sales through indirect channels accounted for 46.9% of our revenues forthe three months ended March 31, 2005 and 36.9% of our revenue for theyear ended December 31, 2004.  Ourrevenues will suffer if we do not expand our sales through, or receive theanticipated benefits from our sales through, indirect sales channels.***

 

We derived 46.9% of ourrevenues for the three months ended March 31, 2005, and 36.9% of ourrevenue for the year ended December 31, 2004 from sales through indirectsales channels, such as distributors, value added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  We believe we must expand oursales through these indirect channels in order to increase our revenues.  Although we are actively pursuing a strategyto increase the percentage of our revenues generated through these indirectsales channels, we cannot assure you that our products will gain marketacceptance in these indirect sales channels or that sales through theseindirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***We must adequately protect our intellectual property in order to preventloss of valuable proprietary information.***

 

We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand non-disclosure agreements to protect our proprietary technology.  However, unauthorized parties may attempt tocopy or reverse engineer aspects of our products or to obtain and useinformation that we regard as proprietary. Policing unauthorized use of our products is difficult, and we cannot becertain that the steps we have taken will prevent misappropriation of ourintellectual property.  This isparticularly true in foreign countries where the laws may not protectproprietary rights to the same extent as the laws of the United States and maynot provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

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***We may incur substantial expenses defending ourselves against claims ofinfringement.***

 

There are numerous patentsheld by many companies relating to the design and manufacture of networksecurity systems.  Although we are notaware of any instances in which our products violate the intellectual propertyrights of others or inappropriately use their technology, it is possible thatthird parties in the future may claim that our products infringe on theirintellectual property rights.  Any claim,with or without merit, could consume our management’s time, result in costlylitigation, cause delays in sales or implementations of our products or requireus to enter into royalty or licensing agreements.  Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license the infringedor similar technology on commercially reasonable terms could seriously harm ourbusiness.

 

***Fluctuations in our quarterly revenues may cause the price of ourcommon stock to decline.***

 

Our operating results havevaried significantly from quarter to quarter in the past, and we expect our operatingresults to vary from quarter to quarter in the future due to a variety offactors, many of which are outside of our control.  Although our revenues are subject tofluctuation, significant portions of our expenses are not variable in the shortterm, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly we may not attain positive operatingmargins in future quarters.  Any of thesefactors could cause our operating results to be below the expectations ofsecurities analysts and investors, which likely would negatively affect theprice of our common stock.

 

***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due to factors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, forthe three-month period ending March 31, 2005, the market price of ourcommon stock on The Nasdaq SmallCap Market fluctuated between $2.10 and $6.20per share.  The market price of ourcommon stock may fluctuate significantly in response to a number of factors,many of which are outside our control, including:

 

•               variations in our quarterly operatingresults;

 

•                  changes in estimates of our financialperformance by securities analysts;

 

•                  changes in market valuations of ourcompetitors;

 

•                  announcements by us or our competitors of newproducts, significant contracts, acquisitions, strategic relationships, jointventures or capital commitments;

 

•                  product or design flaws, product recalls orsimilar occurrences;

 

•                  additions or departures of key personnel;

 

•                  sales of common stock in the future; and

 

•                  fluctuations in stock market prices andvolume, which can be particularly common among network security and other hightechnology companies.

 

***Our recent reductions in our work force may make it more difficult forus to attract and retain the personnel necessary to successfully operate ourbusiness.***

 

We rely upon the continuedservice of a relatively small number of key technical, sales and seniormanagement personnel.  Our future successdepends on retaining our key employees and our continuing ability to attract,train and retain other highly qualified technical, sales and managerialpersonnel.  We have employment agreementswith relatively few**of our keytechnical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future, especially given our recent reductionsin force.  The loss of any of our keytechnical, sales and senior management personnel or our inability to attract,train and retain additional qualified personnel could seriously harm ourbusiness.

 

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***Certain rights of the holders of our preferred stock may hinder ourability to raise additional financing.***

 

We cannot issueshares of capital stock with rights senior to those of our existing 5%preferred stock or Series 2 5% preferred stock without the approval of atleast a majority of the holders of our 5% preferred stock and all of theholders of our Series 2 5% preferred stock, voting or acting as separateclasses.  We also cannot incur certainindebtedness without the approval of at least a majority of the holders of our5% preferred stock.  In addition, holdersof the Series 2 5% preferred stock who are not executive officers ordirectors have the right to purchase a pro rata portion of certain futureissuances of securities by us.  Thecombination of these provisions could hinder or delay our ability to raiseadditional debt or equity financing.

 

***You will experience substantial dilution upon the conversion orredemption of the shares of preferred stock and exercise of warrants that weissued in recent private placements.***

 

On March 25,2004, we completed a $5,000,000 private placement in connection with which weissued 1,000,000 shares of our 5% Convertible Preferred Stock and warrants toacquire 556,619 shares of our common stock. The conversion price for the preferred stock and the exercise price ofthe warrants is $3.144 per share.  Wealso issued our placement agent a warrant for 64,408 shares of our common stockat an exercise price of $3.144 per share. As of May 5, 2005, there were 389,628 shares of 5% preferred stock,representing 619,637 shares of common stock upon conversion, and warrants topurchase 556,619 shares of common stock outstanding.

 

In addition, on March 28,2005, we completed a $2,663,000 private placement in connection with which weissued 1,065,200 shares of our Series 2 5% Convertible Preferred Stock andwarrants to acquire 532,600 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 60,390 shares of commonstock.  The conversion price for thepreferred stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.

 

On May 5,2005, we had 6,138,030 shares of common stock outstanding.  As a result, we expect the private placementsto result in a further dilution to holders of our common stock upon conversionof the preferred stock and exercise of the warrants of 2,898,854 shares ofcommon stock, or an approximately 47.2% increase in the number of shares of ourcommon stock outstanding.

 

Further, theoccurrence of certain specified events controlled by the Company may entitleholders of our Series 2 5% preferred stock to require us to redeem theirshares for a number of shares of our common stock equal to the redemption pricedivided by 75% of the ten-day average of the volume weighted average price ofour common stock ending on the day immediately preceding the holder’s electionto redeem.  The redemption price for theshares of Series 2 5% preferred stock equals the sum of (1) thegreater of $3.25 and the volume weighted average price of our common stock onthe trading day immediately preceding the redemption event multiplied by $2.50divided by the conversion price of the Series 2 5% preferred stock then ineffect plus (2) any accrued but unpaid dividends on the Series 2 5%preferred stock plus (3) any unpaid liquidated damages or other amountspayable to the holders of the Series 2 5% preferred stock.  As a result, assuming we have paid allliquidated damages and other amounts to the holders, accrued but unpaiddividends on May 5, 2005 of $12 thousand, a volume weighted average priceof $2.47, which was the closing price of our common stock on May 5, 2005,and our 6,138,030 shares of common stock outstanding on May 5, 2005, wewould issue approximately 1,875,250 shares of our common stock if a specifiedredemption event occurs and all holders of Series 2 5% preferred stockelected to redeem their shares for common stock.  This would represent an increase ofapproximately 30.55% in the number of shares of our common stock as of May 5,2005.

 

***The conversion of preferred stock or exercise of warrants we issued inour recent private placement may cause the price of our common stock todecline.***

 

The holders of theshares of 5% preferred stock and warrants we issued on March 25, 2004, mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to an effectiveregistration statement we filed on August 6, 2004.  As of May 5, 2005, 610,912 shares ofpreferred stock had converted into 971,551 shares of common stock.  In addition, upon the effectiveness of theregistration statement relating to the resale of the shares of common stockunderlying the Series 2 5% preferred stock and warrants we issued in the March 28,2005, private placement, the investors in that private placement would be ableto freely sell the shares of common stock underlying their shares of Series 25% preferred stock and warrants we issued to them in that private placementupon the conversion of their shares and exercise of their warrants.

 

For the four weeksended on May 6, 2005, the average daily trading volume of our common stockon The NASDAQ SmallCap Market was 176,085 shares.  Consequently, if holders of preferred stockor warrants elect to convert their remaining shares or exercise their warrantsand sell a material amount of their underlying shares of common stock on theopen market, the increase in selling activity could cause a decline in themarket price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

 

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***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

We have made acquisitions inthe past, and, in the future, we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***The payment of accrued dividends on our preferred stock may strain ourcash resources.***

 

Shares of our 5%convertible preferred stock accrue cash dividends equal to $0.25 per share perannum, payable in arrears on March 31 and September 30 of each year,and shares of our Series 2 5% convertible preferred stock accrue cashdividends equal to $0.125 per share per annum, payable in arrears on the firstbusiness day of March, June, September and December of eachyear.  The amount of the dividends on ourSeries 2 5% preferred stock may increase to $0.45 per share per annum uponthe occurrence of certain event entitling the holders of these shares toredemption.

 

During 2004, wepaid $129 thousand in dividends related to our 5% preferred stock and at March 31,2005, we have dividends accrued of $55 thousand related to our 5% preferredstock and $1 thousand related to our Series 2 5% preferred stock.

 

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years ended December 31,2004.  However, we did have sufficientcapital surplus, defined as the amount by which our net assets exceed ourstated capital, based on par value of our outstanding shares as provided byDelaware law.  Although we are currentlyable to pay accrued dividends on our outstanding shares of preferred stock, wecannot assure you that our net assets will continue to exceed our stated capitalor that we will have net profits in order to pay these dividends in thefuture.  These dividends continue toaccrue on our outstanding shares of preferred stock, regardless of whether weare legally able to pay them.  Theaccrual of these dividends may adversely affect our operating results.  In addition, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business. Furthermore, our inability to pay dividends could adversely affect ourability to raise equity financing in the future if required.

 

***Compliance with export regulations may hinder our sales to foreigncustomers.***

 

Certain of our data securityproducts incorporate encryption and other technology that may require clearanceand export licenses from the U.S. Department of Commerce under United Statesexport regulations.  Any inability toobtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

 

Certain provisions of ourcertificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which restricts certain businesscombinations with interested stockholders and could inhibit a non-negotiatedmerger or other business combination.

 

***Our management and larger stockholders exercise significant control overour company and may approve or take actions that may be adverse to yourinterests.***

 

As of May 5, 2005, ourexecutive officers, directors and preferred stockholders beneficially own approximately31.5% of our voting power.  As a result,these stockholders will be able to exercise significant control over allmatters requiring stockholder approval, including the election of directors andapproval of significant corporate transactions, which could delay or preventsomeone from acquiring or merging with us. These stockholders may use their influence to approve or take actionsthat may be adverse to your interests.

 

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Item 3.                                CONTROLSAND PROCEDURES

 

We have carried out anevaluation, under the supervision and the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of March 31,2005, pursuant to Rule 13a-15(b) under the Exchange Act.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective in ensuring that information required tobe disclosed is recorded, processed, summarized and reported in a timely manner.

 

We have carried out anevaluation, under the supervision and participation of our management,including our Chief Executive Officer and Chief Financial Officer, of anychanges in our internal controls over financial reporting that occurred duringthe quarterly period ended March 31, 2005, and our Chief Executive Officerand Chief Financial Officer have concluded that there was no change during thequarterly period ended March 31, 2005 that has materially affected or isreasonably expected to materially affect our internal control over financialreporting.

 

**PART II– OTHER INFORMATION**

 

Item 1.                                LEGALPROCEEDINGS

 

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

 

Item 6.                                EXHIBITSAND REPORTS ON FORM 8-K

 

(a)                                      The following Exhibits are filed with thisreport form 10-QSB:

 

| 2.1(1)  |   | Certificate  of Ownership and Merger merging Intrusion.com, Inc. into Intrusion Inc.                                                                                                                        |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(2)  |   | Amended  and Restated Certificate of Incorporation of the Registrant.                                                                                                                                            |
| 3.2(3)  |   | Certificate  of Amendment to Certificate of Incorporation of Registrant                                                                                                                                          |
| 3.3(4)  |   | Certificate  of Designation for the Registrant’s 5% Convertible Preferred Stock                                                                                                                             |
| 4.1(5)  |   | Certificate of Designations of  the Registrant’s Series 2 5% Convertible Preferred Stock of Intrusion  Inc.                                                                                            |
| 4.2(5)  |   | Specimen  Series 2 5% Convertible Preferred Stock Certificate                                                                                                                                               |
| 4.3(5)  |   | Form of Common Stock  Purchaser Warrant issued to the investors in the Registrant’s March 28,  2005 private placement.                                                                            |
| 4.4(5)  |   | Form of Representative’s  Warrant for the Purchase of Shares of Common Stock issued to certain  affiliates of Stonegate Securities, Inc. on March 28, 2005                                   |
| 4.5(5)  |   | Registration  Rights Agreement dated as of March 28, 2005, by and among the Registrant  and each of the purchasers listed on the signature pages thereto.                                              |
| 4.6(5)  |   | Form of  Voting Agreement executed by each of the officers and  directors of Registrant in connection with the March 28, 2005 private  placement                                                       |
|    |   |                                                                                                                                                                                                             |
| 10.1(5) |   | Securities  Purchase Agreement dated as of March 28, 2005, by and among the Registrant  and the investors listed on Exhibit A thereto.                                                                 |
| 10.2(5) |   | Placement Agency Agreement dated February 7,  2005, by and between the Registrant and Stonegate Securities, Inc.                                                                                       |
| 31.1(6) |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) of the  Exchange Act.                                                                                                             |
| 31.2(6) |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) of the  Exchange Act.                                                                                                             |
| 32.1(6) |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(b) of the  Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |
| 32.2(6) |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(b) of the  Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

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(1)                                 Filed as an Exhibit to theRegistrant’s Definitive Proxy Statement on Schedule 14A in connection withthe solicitation of proxies for its 2002 Annual Meeting of Stockholders, which Exhibit isincorporated herein by reference.

 

(2)                                 Filed as an Exhibit to theRegistrant’s Annual Report on Form 10-K for the fiscal year ended December 31,2001, which Exhibit is incorporated herein by reference.

 

(3)                                 Filed as an Exhibit to theRegistrant’s Definitive Proxy Statement on Schedule 14A in connection withthe solicitation of proxies for its Special Meeting of Stockholders held March 18,2004, which Exhibit is incorporated herein by reference.

 

(4)                                 Filed as an Exhibit to theRegistrant’s Current Report on Form 8-K dated March 26, 2004,which Exhibit is incorporated herein by reference.

 

(5)                                 Filed as an Exhibit to theRegistrant’s Current Report on Form 8-K dated March 29, 2005,which Exhibit is incorporated herein by reference.

 

(6)                                 Filed herewith.

 

(b)                                 During the quarter ended March 31, 2005,we filed the following reports on Form 8-K:

 

•                  Report on Form 8-K filed on March 29,2005, announcing the completion of a $2.7 million private placement.

 

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**S I G N A TU R E S**

 

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| ** **              | **INTRUSION INC.**                                                        |
|-------------------------|---------------------------------------------------------------------------|
|                    |                                                                      |
|                    |                                                                      |
| Date: May 12, 2005 | /s/  Michael L. Paxton                                                    |   |
|                    | Michael  L. Paxton                                                        |
|                    | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                    | (Principal  Financial & Accounting Officer)                      |

 

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